Happy New Year! You want to perform a check-up on your finances. Where should you be putting your money?

I’m searching through my archives and doing a series on classic financial topics called “Back to Basics” . The Vanguard blog recently talked about investing priorities, which compared closely with this 2006 blog post. There is no definitive list, but each person can create their own with common components. Here’s my current list:

Invest in your 401(k) or similar plan up until any match. Company matches typically offer you 50 cents to a dollar for each dollar that you contribute yourself, up to a certain amount. Add in the tax deferral benefits, and it adds up to a great deal. Estimated annual return: 25% to 100%.

Pay down your high-interest debt (credit cards, personal loans, subprime car loans). If you pay down a loan at 12% interest, that’s the same as earning a 12% return on your money and higher than the average historical stock market return. Estimated annual return: 10-20%.

Create an emergency fund with at least 3 months of expenses. It can be difficult, but I’ve tried to describe the high potential value of an emergency fund. For example, a bank overdraft or late payment penalty can be much higher than 10% of the original bill. Estimated return: Varies.

Fund your Traditional or Roth IRA up to the maximum allowed. You can invest in stocks or bonds at any brokerage firm, and the tax advantages let you keep more of your money. Estimated annual return: 8%. Even if you think you are ineligible due to income limits, you can contribute to a non-deductible Traditional IRA and then roll it over to a Roth (aka Backdoor Roth IRA).

Continue funding your 401(k) or similar to the maximum allowed. There are both Traditional and Roth 401(k) options now, although your investment options may be limited as long as you are with that employer. Estimated annual return: 8%.

Save towards a house down payment. This is another harder one to quantify. Buying a house is partially a lifestyle choice, but if you don’t move too often and pay off that mortgage, you’ll have lower expenses afterward. Estimated return: Qualify of life + imputed rent.

Pay down any other lower-interest debt (2% car loans, educational loans, mortgage debt). There are some forms of lower-interest and/or tax-deductible debt that can be lower priority, but must still be addressed. Estimated annual return: 2-6%.

Save for your children’s education. You should take care of your own retirement before paying off your children’s tuition. There are many ways to fund an education, but it’s harder to get your kids to fund your retirement. Estimated return: Depends.

I wasn’t sure where to put this, but you should also make sure you have adequate insurance (health, disability, and term life insurance if you have dependents). The goal of most optional insurance is to cover catastrophic events, so ideally you’ll pay a small amount and hope to never make a claim.

SensibleInvesting.tv recently released a free documentary about the fund management industry and the effect of their high fees on the returns of everyday citizens. “How to Win the Loser’s Game” includes interviews with Vanguard founder John Bogle, Nobel Prize-winning economists Eugene Fama and William Sharpe, author and wealth manager Larry Swedroe, amongst many others. While the publisher is UK-based, most of the concepts are widely applicable to all fund management. The film is broken down into 10 different parts, each about 8 minutes long.

If you are a visual learner and rather watch an educational video than read a book, this documentary is definitely for you. The brief episodes gradually cover the benefits of a low-cost, long-term, low-maintenance, diversified investment strategy. Here’s the trailer, which ends with links to all 10 episodes.

It’s time for some morbid Halloween thoughts! Via an AAII interview with William Sharpe, it appears that the Nobel Prize winner and Sharpe Ratio namesake is working on a software project called Retirement Income Scenarios (blog and software site). It’s not very sleek and I haven’t spent much time with it, but one of the features is a longevity chart:

One of the things that people can do using the illustrative software program available through my retirement income blog is to type in their age and sex and their partner’s age and sex and see the probabilities that both will be alive, that one will be alive or that the other will be alive year by year in the future, based on a set of actuarial tables. Most people don’t want to look at such a graph, but I think it’s important to do so. Most who do this react by saying “that’s a long time, a really long time.”

Sharpe wants people to realize they may live a long time and “scare” them into saving more, working longer, and/or being more careful with their portfolios. Here is the example chart given for retiring couple with male age 66 and female age 63. The green bars show the probability of both spouses being alive at a given year in the future. The blue bars show the probability of just the husband being alive, while the red the bars show the probability of just the wife being alive.

As you can see, there’s a good chance (roughly 40%) that the woman will live another 30 years after retirement. That is a really long time.

So I started up the software and ran the number for something closer to our situation – both male and female currently 36 years old. Here’s the longevity chart produced:

When I examine this chart, I have a different perspective. Being male, I notice that there is a roughly a 10% chance that I won’t make it to age 66. There is a 20% chance (1 in 5) that I won’t make it to 76. The idea of dying before I can actually enjoy retirement – that is scary to me. So yes people can “just” work longer, but also remember that your time on this Earth is limited and not guaranteed. There are many paths out there, but I don’t plan on working hard until 65 or 70 and then hoping I can relax for while before I croak.

Businessweek has an article discussing the difficulties when trying to make a retirement nest egg last for the rest of your life. Most people just worry about the average returns of their investments. But another important concern during the withdrawal phase is sequence of returns risk.

Two retirees can start with the same initial portfolio balance and experience the same average return, but if one experiences highly negative returns in the first few years of withdrawals they can end up with very different outcomes. Instead of explaining this concept with a list of numbers, here is a graphical version from the BW article. Both Jane and John start with $1 million, experience 7% average returns, and take out $50,000 a year with a 3% increase each year for inflation.

Jane ends up 20 years later with $700,00 more than she started, and John is flat broke. Although the sequence of returns shown is a bit extreme, they are simply mirrored and it is still entirely possible.

Some people take this to mean that you shouldn’t retire when the market has been on a good bull run, but I think the point is that you simply don’t know what order your future returns will be. The bull run could keep on going and create a bubble, and then pop many years later. Or something like a declaration of war could crush the market even further even if things have already been bad for a while.

Briefly, a couple of options that can help alleviate this sequence of returns risk are a dynamic withdrawal strategy that continually adjusts to actual returns (no set number every year), and also annuitizing part of your portfolio using a single-premium immediate annuity. Finally, don’t forget the traditional advice of holding a sizable chunk of quality bonds in your portfolio.

When investing, should you focus on income, or total return? I like the idea of living off dividend and interest income, but I also think it is easy for people to reach too far for yield and hurt their overall returns. But what is too far? That’s the hard part. Certainly there are many bad investments lurking out there for desperate retirees looking for maximum income. If possible, I’d like to invest for total return and then live off the income.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund

% of Portfolio

Trailing 12-Month Yield (10/18/14)

Yield Contribution

US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)

24%

1.78%

0.43%

US Small Value
WisdomTree SmallCap Dividend ETF (DES)

3%

2.81%

0.08%

International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)

The total weighted yield was 2.31%, as opposed to 2.49% calculated last quarter. This means that if I had a $1,000,000 portfolio balance today, it would have generated $23,100 in interest and dividends over the last 12 months. Now, 2.31% is significantly lower than the 4% withdrawal rate often recommended for 65-year-old retirees with 30-year spending horizons, and is also lower than the 3% withdrawal that I prefer as a rough benchmark for early retirement. Hurray for zero interest rates!

So how am I doing? Using my 3% benchmark, the combination of ongoing savings and recent market gains have us at 90% of the way to matching our annual household spending target. Using the 2.31% number, I am only 69% of the way there. That’s a big difference, and something I’ll have to reconcile. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years. From that perspective, a 2% spending rate seems extremely cautious.

Here’s an update on my investment portfolio holdings for Q3 2014. This includes tax-deferred accounts like 401(k)s and taxable brokerage holdings, but excludes things like physical property and cash reserves (emergency fund). The purpose of this portfolio is to create enough income to cover all of our household expenses.

Target Asset Allocation

I try to pick asset classes that will provide long-term returns above inflation, regular income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (don’t buy what you don’t understand).

Our current ratio is about 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With a self-directed portfolio of low-cost index funds and low turnover, we minimize management fees, commissions, and taxes.

Last quarter, I had sold my PIMCO Total Return fund holdings. Well, that was lucky on my part with all the recent Bill Gross drama. I decided to sell my stable value fund holdings too as I needed rebalance into more TIPS bonds and I was now able to buy TIPS inside my employee retirement plan using the Schwab PCRA brokerage window. All of our tax-deferred space is now taken up with TIPS and REITs, so the rest of my bonds are tax-exempt munis and savings bonds.

Otherwise, not much new, I rebalanced with new money and reinvested dividends. By this, I mean I don’t automatically reinvest dividends into the same mutual fund or ETF that generated them. Instead, they accumulate for bit and then I reinvest them in whatever asset class has been lagging recently. This also makes fewer tax lots for my taxable accounts.

That’s it for portfolio holdings. In a separate update post, I will update the amount of income that I am deriving from this portfolio.

Now, imagine there are three “levers” that you could pull in order to try and increase your final savings balance at retirement – asset allocation, savings rate, or time horizon. In each case, everything else in the scenario stays the same.

Which single option do you think has the most impact? Taken from the blog post, the results below are based the median balance found after running Monte Carlo computer simulations based on historical returns.

I would look past the absolute values and instead focus on the relative effect of each option. In case you haven’t figured it out, the one piece of investing advice is “save more”. The easiest lever to pull is a more aggressive asset allocation because it doesn’t require the pain of spending less and saving more (though you get more stomach-churning bumps and less reliable results). But here we see that saving just 3% more was equally powerful. If you pulled all three levers, your final balance would have more than doubled!

I’m always interested in non-traditional retirement stories, and saw that the US government just released their final regulations on Phased Retirement for federal workers. Phased retirement in general refers to transitioning from full-time to part-time work for a period of time before a traditional full retirement.

Participants will be able to start working half-time while collecting half of the pension they would get if they were to fully retire at that date. Then, when they fully retire, they’ll get the other half of their pension, adjusted for the additional work they did while being part-time. At least that’s my version of their lengthy explanation:

At entry into Phased Retirement, the employee’s annuity will be completed as if fully retired and then divided by two. That annuity would be paid while the individual worked a half time schedule receiving half pay. […] When the Phased Retiree fully retires, there will be a computation of the annuity that would be payable if the employee had been employed full time and then divided by two prior to adjustment for survivor benefits. That amount would then be added to the original Phased Retirement Annuity, and that combined amount would then provide the basis for survivor annuity adjustment and benefits.

According to this Reuters article, the program should both save money and retain talent:

For the government, the program is expected to be a money saver. The Congressional Budget Office estimated recently that 1,000 employees might take advantage of phased retirement annually, and would continue work for three years. That would cut required contributions to the government’s pension system by $427 million from 2013 to 2022, and boost worker contributions by $24 million.

But phased retirement also will help the government retain talent and expertise at a time when the “brain drain” from an aging workforce is a major concern. About 600,000 people, or 31 percent of the federal civilian workforce, will be eligible for retirement by September 2017, according to the U.S. Government Accountability Office. Phased retirees will be required to spend at least 20 percent of their time mentoring younger employees.

Employess under the legacy Civil Service Retirement System (CSRS) will be eligible for phased retirement at age 55 with 30 years of service, or at 60 with 20 years of service. Federal Employees Retirement System (FERS) employees must be age 60 with 20 years of service, or have 30 years of service and have reached their minimum retirement-eligible age. Agencies can send their Phased Retirement applications to OPM for processing starting November 6, 2014.

I think this is a neat idea and it looks like there will be strong interest. I hope the idea spreads. Even if your employer doesn’t offer an official policy on phased retirement, I know of several folks who have made their own custom arrangements.

Here’s another installment of what I would tell my kids about pursuing financial freedom (if they weren’t still in diapers). Previous topics have included the importance of savings rate and whether to focus on earning more or spending less. This time, I wanted to talk about buying a home and mortgages.

Should you buy or rent? Now, there are many buy vs. rent calculators. Here is the best one in my opinion. But as they say garbage in, garbage out, so be careful. Your answer will strongly depend on unpredictable things like future investment performance and/or home price appreciation. In general, the longer you plan on staying in a geographical location (say at least 5-7 years), the better it is to buy your own place. But if you are the nomadic type and want to travel the world, then renting can work out to be much better. In my experience, buying a house often ends up a lifestyle-based decision and not just about the numbers.

If you decide to buy, my opinion is that you should adjust your mortgage size and term to coincide with the date of retirement. I define retirement as when your expenses are exceeded by your non-work income like pensions, Social Security, annuity payments, stock dividends, rental income, or other investment income. Example scenarios:

If you love your job and plan on working for the next 30+ years, then go ahead and get a 30 year mortgage. Maybe you have a job that you could work part-time or isn’t very stressful. In this case you have lots of human capital and a long stream of future work income. Take on the 4% interest rate fixed for 30 years, and over time your salary will rise with inflation while your payment stays the same. Be sure to buy a house that you can afford while still investing for retirement. If anything, you could do a DIY biweekly payment plan and pay off that 30-year mortgage in under 24 years.

If you have the early retirement bug and want to retire in 15 years, then you should find a home that you can afford with a 15-year mortgage. The interest rate will be lower and as long as you can swing the payments in the beginning, you’ll quickly get used to it. The hard part is to find an affordable home with those higher monthly payments. The hardest part is to be satisfied with it as you’ll have the option and expectation from others to spend more. This is why I think the 15-year mortgage is a powerful tool for aspiring early retirees. It forces you to commit to a long-term lifestyle that fits your goals. Buy a house at age 25, and you’ll be done by 40.

Let’s say you receive a monetary windfall (inheritance, huge raise, IPO) and all of a sudden an early retirement is on the table. I wouldn’t necessarily pay off the mortgage completely if you aren’t ready to retire yet. You’ll want to balance the opportunity to invest in potentially higher-returning investments (stock mutual funds, dividend-paying stocks, other real estate) with pursuing the benefits of having a fully-owned house (less stress, less leverage, lower required monthly expenses). My solution would be to pay enough of the mortgage down such that with your usual monthly payments it advances your mortgage payoff date to match your retirement date. If you won the lottery and that date is tomorrow, then yes pay it all off!

One of my reasons for matching mortgage payoff with retirement date is psychological. When you are working, your paycheck is the same every month. This matches well with a fixed mortgage payment. But investment income is often variable. If the tenant in your investment property decides to squat and you have to spend months going through eviction proceedings, your rental income may drop to zero for a while. Many experts now recommend a dynamic withdrawal strategy from your investment portfolio, which would also result in a variable income. But mortgages are like an alligator. You must feed it; if you don’t then it eats you. Other expenses like travel and dining out, those can be adjusted. So I don’t like the idea of having a mortgage in retirement, especially if it is a large percentage of your overall expenses.

However, paying off the mortgage too early can also cause regret if the stock market is rising while you’re piling money into a 4% mortgage. If you are still in the accumulation phase, at times like now you’ll be reminded that you could be investing your paycheck in the market generating higher returns. But if you’re retired, that meant your nest egg was already big enough. If the market goes up, your next egg goes up and you are happier. If the market drops, hey, you already have a paid-off house. So that is why I don’t recommend paying off the mortgage too early, either.

Finally, early retirement with a paid-off house is great because lower expenses means smaller withdrawals from your portfolio, which also means a lower overall tax rate. In fact, with a mix of Traditional and Roth IRAs, we’ve seen that a couple could withdraw over $50,000 a year and still pay zero taxes on retirement. A lower income can also help you qualify for things like health insurance subsidies.

Short version to my kids: If you want to retire early and don’t move around much, buy a modest home where you can afford a 15-year mortgage payment and save at least 25% of your income. If your lifestyle entails lots of moving around, rent and save 50% of your income.

In addition to subsidies on health insurance premiums, the Affordable Car Act (ACA) provides subsidies on out-of-pocket costs to qualifying households when buying insurance from an exchange. The income requirements are more restrictive, but they further improve affordability for those with lower incomes by reducing their deductibles, copayments, coinsurance, and total out-of-pocket maximum limits.

Income eligibility requirements. In this case, the income cutoffs are 200% and 250% of the Federal Poverty Level (FPL). Modified adjusted gross income (MAGI) is used for income. Modified takes your AGI (Line 4 on a Form 1040EZ, Line 21 on a Form 1040A, or Line 37 on a Form 1040) and adds back in certain deductions like non-taxable Social Security income, foreign income, and tax-exempt interest.

For reference, here are the 2014 FPLs by household size listed with the 200% and 250% levels, as calculated by the Department of Health and Human Services (for 48 contiguous states, higher in Alaska and Hawaii).

2014 POVERTY GUIDELINES FOR THE 48 CONTIGUOUS STATES AND THE DISTRICT OF COLUMBIA

Persons infamily/household

100% FPL

200% FPL

250% FPL

1

$11,670

$23,340

$29,175

2

$15,730

$31,460

$39,325

3

$19,790

$39,580

$49,475

4

$23,850

$47,700

$59,625

5

$27,910

$55,820

$69,775

Deductible, copayment and, coinsurance subsidies. These cost-sharing subsidies are only available if you start with buying a Silver plan. Now, the idea of a Silver plan is the insurer will pay 70% of covered health expenses across the entire population, leaving the insured to pay 30%. However, if your income is 150% FPL or less, you’ll only have to pay 6% of covered health expenses. If your income is between 150% and 200% FPL, you’ll only pay 13%. If your income is between 200% and 250% FPL, you’ll have to pay 27%.

Each plan will have a different way of implementing this overall requirement, usually by tweaking deductibles and copays. These may be referred to as Cost Sharing Reduction (CSR) plans.

Out-of-pocket maximum subsidies. The Affordable Care Act limits your maximum out-of-pockets expenses per year. Once you reach this limit, your insurance will pay for all of your covered healthcare expenses for the rest of the year. However, if you are under 200% or 250% FPL, these limits are even lower.

Modified Adjusted Gross Income

2014 maximum annual out-of-pocket cost, individual

2014 maximum annual out-of-pocket cost, family

100-200% FPL

$2,250

$4,500

200-250% FPL

$5,200

$10,400

> 250% FPL

$6,350

$12,700

Note that you may read conflicting information elsewhere about reduced out-of-pocket limits being available to anyone at 400% FPL or less. That information is outdated (source). Those numbers were in the original law, but it was since revised to what is shown above.

Recap. These subsidies for out-of-pocket expenses provide another important income cutoff point to consider when purchasing health insurance independently from an employer plan. Your total healthcare expenses could vary significantly if your income is just $1 over the cutoff points of 200%, 250%, and 400% FPL.

Rarely are people who achieve a non-traditional retirement profiled on mainstream media, and when they do it’s usually with a “omigosh look at these crazy people” type of article. So I was surprised when I ran across this couple who talk casually about saving 50% of their income and taking year-long vacations every few years on a Nationwide Insurance commercial. Via ERE Facebook page.

“The key is living like you did when you were a student,” says Rich Ligato, 45, who lives in San Diego. While not completely financially independent, Ligato and his wife, Amanda, stopped working steady jobs more than a decade ago. Their goal is working for three years, taking odd jobs, saving their money, then enjoying a year-long vacation break, doing something such as living in India or biking along the Western coast of the U.S. When they return, they take entirely different jobs.

Rich is currently teaching biking classes and managing an apartment, while Amanda is teaching yoga. “It’s not about money, it’s about freedom,” he says. “If you’re just driving to make things secure and safe, think about what that means. There’s nothing interesting in life. You might as well die.”

(Updated to add: I haven’t read the financial particulars of their situation, but given their 50% savings rate alone the math would say they could work one year and take the next year off if they just kept their spending rate constant. But they work 3 and take 1 year off. So even if they spend double what they do when working, then they could put away 1 year of savings for retirement, and then spend the other 2 years on their year-long vacation. That’s still more than the average person puts away (1 full year of expenses every 4 years, or 25% of their combined annual salary every year). This may be off, but roughly how I imagine it working out.)

I always get excited by stories like this; they may not be “retired” but they are living consciously and achieving their dreams. (I’m really looking for one of these stories where they have kids and travel the world.) I still bought their book and starting reading it already. Not sure how new this is, but Amazon does this neat thing now when you order a physical book, they let you start reading the beginning on the Kindle while you wait for it to arrive. Nice for us who prefer physical books but are also impatient. 😉

The current “full” retirement age for Social Security is 66, although you have the option to start taking benefits at a permanently reduced rate at age 62 (did you know that over 35% of people take this permanent ~25% cut in benefits!). The full retirement age for Social Security in the US is 67 years for workers born after 1960, but that is always subject to future change. Here’s a Wikipedia page comparing the current “standard” retirement ages in various countries.

Why do I bring this up? Last month, Australia announced that it plans to increase its official retirement age to 70 by the year 2035. Here’s an AARP article about 14 countries — including Germany, Italy, Spain, Greece and Ireland — who are planning to increase their retirement ages to between 67 and 69 by 2050.

I’m in my mid-30s now, and unlike some I still expect Social Security to be around for a long time. But I also predict that the full retirement age for Social Security will be raised in a similar, and that I won’t get full benefits until age 70.

Check out how the math is working against younger workers, via Businessweek:

Also consider that 1 in 3 people born today are expected live to 100, so for the system to work they’ll likely be expected to work at least 50 of those years. That could be 50 years of 50-hour workweeks (especially if you include commuting) for 50 weeks of the year. Yikes. No wonder I like to learn about the principles behind financial freedom, so I can teach them to my kids!

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